Investing in ‘the Market’ is Far Riskier than You Think

Berkshire Hathaway’s Annual General Meeting (AGM) is like Woodstock for capitalists.

Hundreds of thousands of investors make the trip out to Omaha each year.

Their reward? Words of wisdom from two old capitalists — 87-year old Warren Buffett and 94-year old Charlie Munger.

Berkshire’s 2017 AGM was like every other.

Buffett started the meeting by introducing the managers and going over the latest quarter. But before taking questions from analysts, he set aside time to make a very special mention.

If a statue is ever erected to honour the person who has done the most for American investors, the hands down choice should be Jack Bogle,’ Buffett wrote in the annual report.

Jack is the pioneer of index funds.

You might have heard of his company. In 1976, Jack created the first Vanguard index fund.

Today Vanguard manages more than US$4.5 trillion for investors. And for decades he’s helped investors earn far more and pay far less by investing in ‘the market’.

For this, Jack is ‘a hero to them (investors) and to me,’ Buffett said.

But if the market falls lower, is it really time to be piling into indexes?

How can US$5 trillion be wrong?

There is A LOT of money in passively managed funds. Meaning investors buy the index or exchange traded funds (ETFs).

According to latest figures, investors put more than US$100 billion into ETFs during January this year. It’s was a new record on a monthly basis.

It now pushes total funds in ETFs to over US$5 trillion.

And why not put it in the market? Until a few days ago, stocks around the world were going up.

US stocks were up more than 25% last year. Aussie stocks were up almost 8%. Chinese technology stocks smashed all expectations, rising more than 35%.

Many expected 2018 to be more of the same.

What’s more, investors are told investing in an index or ETF is far safer than the alternative, holding picked stocks.

So not only can you make amazing returns, you can also take on far less risk. Dreams do come true.

But try telling that to anyone who bought an ETF tracking volatility.

Investors in the VelocityShares Daily Inverse VIX, which tracks volatility of futures indices, made more than 180% last year.

But last Monday, that same ETF came crashing down.

VelocityShares Daily Inverse VIX made more than 180% last year. 13-02-2018

Source: Australian Financial Review
[Click to enlarge]

It hasn’t been a picnic for those who recently bought index funds, either.

They’ve seen the market come off its highs, with potentially more declines to come.

Its why in February, investors did a complete 180. Instead of piling more money into ETFs, they’ve taken out more than US$19 billion.

Some of this money is moving into bonds. Some of it is just nervous investors scared of losing more.

It seems the time to grab quick, easy gains by throwing your money into the market is over.  And investors now need to be aware of the risks when buying an index fund or ETF. 

Diversification does not mean riskless

What’s your definition of risk?

Something is risky if there’s a high probability to lose money, right?

Therefore, risk is the chance of permanent capital loss.

Yet if you ask academics or institutional investors, they might tell you risk is volatility. Meaning something that goes up and down more often is more risky.

Based on second definition, index funds and ETFs are less risky than picking individual stocks.

Because ‘the market’ includes so many companies, returns even each other out. Thus, you have stability in your portfolio (most of the time).

But based on the first definition, buying a small group of stocks is no riskier than buying an index fund or ETF.

In fact, you could say you’re taking on less risk buying individual stocks than investing in ‘the market’.

That’s because you have the chance to select each stock. You can weigh up future probabilities of which will outperform over the next few years.

You can then build a portfolio of undervalued stocks that you believe will climb significantly over time.

It’s a method Buffett has followed for decades. And look how brilliantly he’s done.

Build a portfolio of undervalued stocks you believe will climb significantly over time. It’s a method Buffett has followed for decades. 13-02-2018

Source: Market Watch
[Click to enlarge]

Of course not everyone has the same ability as Buffett. And that’s where index funds and ETFs come in.

But just because you’re diversified, don’t think you’ve cut out risk completely.

It’s time for intelligent stock picking

I expect you’ll see more market declines as we head further into 2018.

In yesterday’s Money Morning, I showed you the typical size (13.2%) and length (2.3 years) of an All Ordinaries correction.

So if we’re destined to head lower, it might be the perfect time to set yourself up to profit when the market picks back up.

It’s hard to go against the herd. But right now is the perfect time to use the cash you’ve stored up to jump on beaten down, high returning businesses.

I won’t be surprised if Buffett and Munger tell shareholders the same thing in their 2018 AGM in May.

Kind regards,

Harje Ronngard,
Editor, Money Morning

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